Saturday, January 30, 2016

We continue to receive questions about the impact of the recent dollar strengthening on the US economy. The most immediate impact of course is on trade, which has created an immediate drag on the GDP growth.

Source: St Louis Fed, Goldman Sachs

We know that the impact on US industrial production in particular has been terrible.

On the other hand this currency appreciation, combined with weaker energy prices, is supposed to improve consumption as imports become cheaper.

The chart shows US import price index

And of course all the cheap fuel (combined with a warmer winter) should be providing material support to US households.

US average gasoline price

Will that be enough to give US consumer spending a boost? Goldman outlines two potential scenarios, the second one of which leads to a contraction in US gross output.

Source: Goldman Sachs

The full impact of the US dollar rally thus depends very much on the behavior of the consumer in the months to come. From a balance sheet perspective US households certainly don't seem to be "stressed", as the Financial Obligations Ratio remains near multi-decade lows.

Whether this will translate into stable spending patterns remains a question. According to Gallup, at least through December, US consumer spending has been solid.

Source: Gallup

The equity markets however are now pricing in a much weaker discretionary spending pattern, while companies focused on staples seem to be doing much better. Note that much of the divergence has taken place this year. Is the market concerned about consumer retrenchment?

Source: Ycharts

The December GDP report (0.7% growth) showed that growth has already slowed as financial conditions tightened. A great deal of this tightening has been driven by the US currency appreciation.

Source: @jbjakobsen

Consumer spending stability in the next few months is therefore critical. Strong US dollar has created a significant drag on economic activity but economists are betting that the consumer tailwinds should support growth,. If however the consumer (spooked by the recemt sharp correction in the equity markets) retrenches, US growth could stall.

Sunday, January 24, 2016

The realignment of currencies in the past 18 months has been the most dramatic in decades. A perfect storm is occurring: Federal Reserve tightening; Eurozone and Asian monetary easing; and a collapse of major commodities, all conspire to drive just about every currency in the world to lower values against the USD. Governments are anticipating that this re-alignment will revive economic growth, lead by the external sector. How likely is to happen?

Two recent studies, from the IMF and OECD, draw attention to the question of
how effective are devaluations in changing the fortunes of "open" economies. The term "open" refers to those economies which generate a significant portion of national income from exports, such as Germany, Canada, and several Asian economies. Before reporting on the studies, it is helpful to get a sense of the reasons behind devaluations, the extent of currency adjustments and the importance of exports to major trading nations.

Table 1 groups these devaluations by size and by importance as measured by the contribution of exports to national income.

* Depreciation in excess of 25% The greatest depreciations has happened in those countries that are highly dependent on commodity exports, --- Russia, Canada, Australia and South Africa. The worldwide collapse of major commodities resulted in significant declines in their respective trade accounts and national income. Commodity markets are over-supplied and these currencies are not expected to recover anytime soon .The big concern is when will commodity cycle reach bottom and for how long will they remain there.

*Depreciations of 20-25% . This group includes both manufacturing exporters
( eg Germany) and natural resource exporters ( eg Sweden). The European currencies have adjusted downwardly in part a reflection of the EU debt crisis and domestic deflation.

* Depreciations of 10-20% This group includes highly industrialized countries such as Japan and the UK , countries that have benefited from lower commodity prices, and

* Depreciations of less than 10%. The final group features emerging economies,
( eg China, India) that convert imported raw materials into intermediate and final goods for export.

No major trading country escaped the surge in the USD last year, a condition that is carried forward into 2016, especially in the wake of further declines in oil and other major commodities.

The IMF Study

The IMF study starts with two basic questions: how responsive are exports to changes in the exchange rate; and has that responsiveness changed over time?(1) The agency estimates the "elasticity of demand"; this measures how price changes affect demand. A number equal to or greater than 1 indicates that demand for exports is very sensitive to exchange rate changes ( ``elastic``) a number less than 1, demand is less sensitive to exchange rate adjustments (``inelastic``). (2).

The IMF examined dozens of countries and several sectors over a 15-year period . Their findings are summarized in Table 2. Exports are less sensitive to exchange rate movements over time; half as much in the case of all exports and nearly half as much in the case of manufactured exports. That elasticity has lessened over time and across sectors casts doubt on the effectiveness of the recent currency realignments in promoting growth of exports.

The IMF researchers offer some explanation for why demand for exports are less responsive to exchange rate depreciation compared to previous decades. First, worldwide trade has slowed, especially since the 2008 crisis, although the IMF points out that the change in elasticity pre-dates that financial crisis year.
Secondly, a more important reason is offered. The IMF states "intuitively, as countries are more integrated in global production processes, a currency depreciation only improves competitiveness of a fraction of the value of final good exports" (1)
. This explanation leads us to the OECD study on importance of the foreign value added in determining the effectiveness of depreciating one's currency.

The OECD Study
The OECD examined one aspect of globalization that relates to devaluation and export performance. It recognized that a country`s exports are increasingly reliant on intermediate goods imported from foreign suppliers. The agency measures
"trade in value added" in which it traces the value added in each country and in each industry as part of the production chain leading to final exports. Often overlooked is that devaluation raises the cost of imported inputs. The more a country is integrated within the worldwide supply chain, the less it can expect a currency depreciation to drive export growth--- the high cost of imports mitigates much of the advantages of a lower currency.

Take the case of Canada .(Chart 1). Canadian exports contain 25% foreign value added, more than that of the US , its largest export market and competitor. The comparison is even more pronounced in the case of transportation equipment. Canadian transportation exports contain more than 50% foreign content ; the US contains only 29% imported value added . Transportation exports comprise the second largest export sector in Canada after oil. This degree of reliance on foreign content suggest that the devaluation of the Canadian dollar will have limited effectiveness in improving the trade imbalances .

So,will devaluation work as a means to stimulate export growth and trade in general? Canada is a good case in point.

At the global level, trade is expected to expand at less than 3% this year, one of the slowest paces since 2000. The forces that lead up to the currency re-alignments, namely a collapse in commodity prices and a slowdown in world manufacturing continue to plague the world. Canadian non-energy exports have to contend in this difficult environment.

As long as commodity prices remain down for long count, Canada will not see any marked improvement in its trade balances . Many observers are pinning their hopes that fall in the Loonie will promote the expansion of non-energy exports. However, it is more likely that Canadians will undergo a fall in their standard of living as long as oil prices remain at these current levels. Simply, the slack is too great to be picked up by non energy exports alone.

Canada relies heavily on the worldwide supply chains for production of exports, more than its US competitors .This integration works against the perceived advantage of a lower Canadian dollar.

No longer can we expect devaluation to be a panacea.
________________________________

1) IMF, "Depreciations without Exports ?" (2015)

2) The negative sign indicates that the exchange rate and quantity demand are inversely related.
_________________________________________________________________________

Tuesday, January 19, 2016

It seems like every day we are inundated with news out of China. Investors are already concerned. The offshore renminbi (CNH) is more international than the onshore one (CNY), which is tightly managed by the government. As such, the rising spread (CNH-CNY) between the two may be indicative of mounting skepticism about China’s economy and its markets. Likewise, capital is fleeing the country as hot money flows have accelerated:

Source: @vikramreuters

In the following sections we will attempt to analyze China’s markets and determine the biggest risks facing its economy. Lastly, we will try to answer the following question: does it matter to us?

Financial Markets

As the first week of trading in 2016 came to an end, the Chinese markets had already been halted twice. Newly minted circuit breakers, which have since been suspended, were triggered when China’s main equity index, the CSI 300, fell 7% on two separate occasions. The first selloff was triggered by a rumor that the China Securities Regulatory Commission (CSRC) was planning to suspend a short sale ban that has kept a reported ~$185 billion off the market. Subsequently, the CSRC decided to extend the ban in order to calm the markets. The second drop followed a significant devaluation of yuan by the People’s Bank of China (PBOC). China has also backtracked on that move. Basically, the Chinese markets are confusing…

That said, the volatility is not surprising considering how unsophisticated China’s market is. One university study found that 2/3 of the new investors at the end of 2014 did not have a high school diploma:

Source: Bloomberg Brief

Along the same lines, individuals account for at least 80% of trading on the mainland exchanges. In other words, there are many speculators and few investors. China’s markets are undeveloped and relatively unimportant. Nonetheless, they may offer some clues into consumer sentiment and the government’s ability (or inability) to control the economy.

In regards to trade, China is the world’s biggest player. In 2013, it led the world in exports ($2,209 billion) and was the number two country for imports ($1,950). The combined value of its trading amounted to $4,159 billion, marginally higher than the US’ $3,909 billion.

Debt

China’s aggregate debt level is one of the highest in the world, although it may not seem to be at first glance. China’s government debt-to-GDP ratio is 55%. To put that in perspective, the US and Japan are at 89% & 234%, respectively. Even so, it is always prudent to consider a country’s debt composition. China’s mounting debt comes into focus when we account for non-financial corporate debt (125% of GDP), financial institution debt (65%) and household debt (38%). The grand total is an astounding 282% of GDP, or $28.2 trillion:

Source: McKinsey

The rate of debt growth is also a concern. Non-financial corporate debt, increased from 72% to 125% of GDP from 2007 to 2Q14, a 73.6% increase.

China’s debt load is a global risk because of how tightly managed its economy is. The government has allowed unprofitable companies to stay in business. Though defaults have been very limited, China must allow these companies to fail eventually. Otherwise, it will continue to suffer from high debt servicing costs (~30% of GDP).

Overcapacity

Government investment has been a big part of China’s economy. Massive amounts of stimulus went into factories, leading to overcapacity in sectors such as coal and steel. This is making it very difficult for companies that operate within those sectors to make profits – both domestically and abroad. Fiscal stimulus also went into housing and infrastructure, which are both clearly overbuilt. Despite the overcapacity, gross capital formation still represents ~45% of GDP:

The PBOC has been very active trying to support the economy. It has cut rates 6 times since November of 2014. Likewise, it has been lowering its Reserve Requirement Ratio and selling its foreign reserves in an attempt to prevent excessive devaluation of the yuan (CNY). They are down more than $400 billion (from a peak of ~$4 trillion) since mid-2014:

Source: @TomOrlik

FX is also a risk because China has a great deal of USD-denominated debt. In mid-2015, non-bank borrowers held ~$1.2 trillion worth of it. This debt becomes more expensive as USDCNY rises, which is exactly what the markets expect to happen.

Corruption Crackdown

China’s anti-corruption campaign is a step in the right direction. That said, it is a big political risk for foreign investors. High profile businessmen and officials have been disappearing while others are being investigated. Moreover, securities regulators have been cracking down on market manipulators, “ensnaring some of the nation’s most high-profile money managers and announcing more than 2 billion yuan of fines and confiscated gains” (source: BBG Brief). Critics of the campaign suggest that it may deter business while failing to address the corruption that exists within the ruling party.

Implications

As investors, we should be concerned because China is one of the biggest economies and the world’s leading trader. Therefore, if it slows down then so will global growth:

Source: Goldman Sachs

China is also important because it is a massive source of demand for many commodities. Thus, its weakness is spreading to undiversified economies such as Russia, Brazil, and South Africa. Recessions in those countries might not spill over to the rest of the world. Nevertheless, it is important to consider the amount of debt they have accumulated since the financial crisis. In the US, credit is already tightening. If borrowing costs rise for the emerging markets, especially China, then we may see a wave of defaults with untold consequences.

-$hane Obata & Richardson GMP AMThe opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author's judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. The comments contained herein are general in nature and are not intended to be, nor should be construed to be, legal or tax advice to any particular individual. Accordingly, individuals should consult their own legal or tax advisors for advice with respect to the tax consequences to them, having regard to their own particular circumstances.. Richardson GMP Limited is a member of Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons.

Sunday, January 17, 2016

Trepidation is often defined as a worry or fear of what is going to happen. This best describes the feeling many Canadian investors have regarding the economic outlook for 2016. It all started with the dramatic collapse of world oil prices in 2014, the continued decline through 2015 and then into January 2016. To get a better appreciation of why there is growing concern for 2016, let us review the basic developments of 2015 and how they may impact on developments in 2016.

Table 1 identifies some of the key economic developments of 2015 that are now weighing on our minds as we launch into 2016.

* Economic growth. The year 2015 started off badly as the economy contracted, and, by the summer GDP had fallen for two consecutive quarters, technically a recession. The Q4 will likely be slightly positive, but for the year as a whole, observers expect GDP will be near 1%. Not a good handoff to 2016

* Unemployment. The unemployment rate crept up during 2015 from 6.8% to 7.1%. More significantly, the quality of job creation leaves a lot to be desired. In December, for example, the economy created 23,000 additional jobs; however there was a loss of 17,000 full time paying jobs against a gain of 40,000 self-employed workers.

*Inflation. The rate of price increases slowed considerably, largely in reaction to the fall in gasoline prices. This is a mixed blessing for a country that relies so heavily on oil exports.

*Terms of Trade. The prices we receive for our exports have fallen relative to the prices of imports, resulting in a decline in national income. The Bank of Canada estimates that the decline in the terms of trade has resulted in a loss of $50 billion a year or $1,500 per person per year.

* Oil Prices. The continued slide in oil prices has had a dramatic effect on capital investment, especially in the Oil Patch. This has resulted in significant job losses in western Canada which continue to this day. The industry mantra regarding prices is ``lower and longer``; the question is how much lower will prices fall and for how much longer. Already January's price decline of 10% is roiling the financial markets everywhere.

* Canadian Dollar. In the wake of the strong upward movement of the USD, the CDN has fallen sharply over the year, forcing Canadians to make unwanted adjustments in the purchase of imported goods (especially food) and in international travel. Consumer confidence has been hurt by the dollar's almost free fall.

Essentially, the drop in oil prices is now reverberating throughout the whole country. As the Governor recently admitted, "the forces that have been set in motion simply must work themselves out"(1). It is no wonder that the mood in Canada is subdued and there continues to be a feeling that we are powerless in dealing, in the short run, with a deteriorating economic situation.

The Canadian stock exchange, the TSX60 is heavily weighted in energy and bank stocks. The resultant 12% decline in 2015 was one of the largest in recent memory. This trend continues in the first week of January 2016 when the index fell another 7%, adding to investors' woes. Recently, a Bank of Canada survey of business conditions, revealed that business respondents predicted a further decline in investment plans for 2016. The commodity bust is now starting to seep into other sectors of the economy.

With deflationary forces well entrenched, short and long term interest rates fell significantly during 2015. The Bank of Canada lowered its rate twice, dropping the overnight rate from 1% to 0.5% in response to the deteriorating domestic economic conditions. Housing was the only bright spot in 2015. Nationally, the average home price increased by 10%; although the market was heavily skewed to the very lofty prices in Vancouver and Toronto, the rest of Canada experienced modest price increases ( Table 2).

Policy Responses
In a recent speech, the Governor of the Bank of Canada, adopted a 'made -in-Canada' monetary policy. This policy diverges from that of the US where the Federal Reserve is on track to raise short term rates over the course of the next 12-18 months. The Governor stated "we will continue to conduct an independent monetary policy in response to our own economic circumstances in order to meet our 2 percent inflation target"(1). He cited a range of conventional and unconventional tools that are available to promote growth. In fact, many analysts expect the Bank to lower its rate later this year in effort to boost growth, further entrenching the theme of divergence in monetary policy.

Benjamin Tal of the CIBC claims: "It's becoming very obvious that monetary policy is not the solution. The Governor admitted that a low currency is our only hope but the benefit of cutting rates in order to get another cent or two out of the dollar fades relative to the damaging impact on household leverage" (2). In other words, there is a concern that dropping short term rates will only fuel the housing market-- a market that some consider to be overheated considering household debt levels. This brings us to the most controversial aspect of the Canadian environment: will housing prices finally crack under the weight of a deteriorating economy?

There are many ways to measure the vulnerability of housing prices to household leverage. For American readers this topic also resonates, having endured one of the largest housing collapses in modern history starting in 2007. In a recent study by the staff of the Bank of Canada, summarized in Table 3, debt ratios are compared between Canada in 2012/4 with those in the U.S. in 2007. Canadians are not nearly indebted today as the Americans were in 2007. For example, Canadian households with debt service ratios of 40% plus (a major threshold level) comprise only 36% of all household, compared to 71% of US households in 2007.

Given the limitations on monetary policy, we have to look to fiscal policy to improve the economic climate. The Federal Government will introduce a budget in February which is expected to feature infrastructure spending across the nation. The remaining hope is for a stimulus package. Meanwhile, Canadians continue to feel a degree of vulnerability. We start the new year with considerable unease.

Bets against the FOMC's forecast gained momentum after significantly worse-than-expected US industrial production, capacity utilization, and NY manufacturing reports. In fact the NY Fed manufacturing figure was so bad, many initially thought it was an error. Welcome to the world of strong US dollar ...

As a result, the implied probability of 4 (or greater) rate hikes in 2016 (as predicted by the dot plot) dropped from 4.7% on Wednesday to under 1% on Friday. On the other hand, the probability of no hikes this year doubled in just two days.

Source: CME

An alternative way to look at this shift in probabilities tells us that the next Fed hike is now not expected until September.

This has significant implications for the US dollar and risk assets. If the Fed is indeed on hold for some time, with possibly just one hike this year (if that), we should see the dollar come under pressure and commodity prices stabilize.

Sunday, January 10, 2016

As discussed in the previous post (here), the markets have completely discounted the stellar US payrolls report when projecting the Fed's policy path in 2016. Futures-implied probability of 4 rate hikes (or higher) is only 6.5%. Why is the market so "dovish" relative to the FOMC?

As a backdrop, we now know from the FOMC minutes that the Committee members were quite jittery about disinflationary pressures, with many being ambivalent in their decision to raise rates in December.

Source: FOMC Minutes, FRB

Is the long-awaited jump in inflation about to make itself visible? Market participants remain skeptical. Here are some key reasons.

1. Most analysts have been forecasting - for some time now - a significant increase in US wages as the labor markets tighten. However thus far we have seen little evidence for this "acceleration", with wages persistently growing below 2.5% per year.

2. With US crude oil prices below $33/bbl, many believe the energy impact on inflation is yet to be fully reflected in the official figures. Moreover, some think that weak energy prices will even partially bleed into the core PCE inflation measure (on a delayed basis).

Source: Investing.com

3. China's ongoing devaluation will continue putting pressure on prices in the US as well.

As an example, the December jump in iron ore prices has been nearly fully reversed as China-related worries returned. In addition to China's impact on commodities, most expect US import prices to fall further, also igniting disinflationary concerns.

Source: barchart.com

Of greater concern is whether China will continue devaluing the yuan further in order to stimulate its export sector. This could lead to "competitive devaluations" - or what some refer to "escalation of currency wars". Here is a quote from Mexico's finance minister.

FT: - “There is real concern that, in the face of the deceleration of the Chinese economy, the public policy response will be to start a round of competitive devaluations,” said Luis Videgaray, finance minister.

He called that prospect “frankly perverse” because copycat devaluations would leave everyone in the same position and would not really alter anything. Mexico’s peso floats freely, but the central bank has been auctioning dollars in recent months to shore up the currency.

Such an outcome will be highly deflationary, resulting not only in further weakness in commodity markets and US import prices but also in a wave of shifting production and services offshore. Consider the fact that just over the past year the Mexican peso is down 18% - now at the weakest level on record. Shifting production and even some services out of the US becomes increasingly compelling.

In fact the trade-weighted US dollar index is now at the highest level since 2003 and "offshoring 2.0" could be the next major trend for US businesses. This of course doesn't bode well for stronger wage growth.

4. We've already seen some of the impact of this dollar strength in the struggling US manufacturing sector. Growth in US services sector is moderating as well (see summary). Does it make sense to hike rates aggressively in such an environment?

5. Given some of the trends above, market-based inflation expectations remain near the lowest levels since the Great Recession. While a number of analysts as well as many Fed officials view this as a "transient" effect, these measures have remained stubbornly low for some time now.

6. Finally, a number of economists are becoming concerned about aggressive rate hikes at a time when the corporate sector is about to undergo deleveraging.

Source: Citi research

Of course we know that all the years of highly accommodative monetary policy in fact caused corporate leverage to rise to begin with (see post from 2014). Nevertheless, with a number of analysts calling the end of the credit cycle, managing this deleveraging process should become a consideration for the Fed this year.

Source: Citi research

These are some of the key reasons markets view four or even three rate hikes as being off the table for 2016. Some are even calling for the Fed to take rates back to the 0-25bp level. It's unlikely the FOMC would do this because such an action would damage the central bank's credibility. Nevertheless some are hoping the Fed would pay more attention to what the ECB is currently doing.

On Friday the US Department of Labor report on US payrolls was significantly stronger than expected. Given such excellent economic news one would think the FOMC is going to continue on its path of steadily raising rates.

Source: Investing.com

Fixed income markets however don't believe that to be the case. The chart below shows the January 2017 Fed Funds futures contract over the past 3 days. The higher the value the lower the implied Fed Funds rate. The contract initially sold off sharply upon the announcement of the jobs figures but rallied shortly after. It ended up higher than it was prior to the report, indicating that the market expects the Fed to actually be less, not more aggressive in raising rates - even in the face of this strong employment report.

Source: barchart.com

The FOMC dot plot in December indicated that the Fed will hike rates four times in 2016. Surely with such an unexpected improvement in jobs, the Fed has to follow up on its "promises".

Source: FRB

Nonetheless, markets are completely discounting this projection, assigning only a 6.5% probability to a 4 or higher number of hikes in 2016. The chart below shows the futures-implied probability of rate hikes in 2016, with the horizontal axis representing the number of rate increases. This 4-or-higher probability is in fact materially lower than it was a couple of days prior to the payrolls report.

Source: CME

We saw a similar reaction in the treasury market, with the 2-year note futures reversing the sharp selloff which occurred when the report came out - and finishing higher than it started. So much for the treasuries selloff many have been expecting.

In the next post we will explore why the markets are discounting the latest US jobs reports in projecting the near-term Fed Funds rate path.